U.S. Office Vacancies Hit 15.2% -- and Rising

Struggling to cut costs in a raging recession, companies dumped a near-record 25 million square feet of office space in the first quarter, driving vacancy up and rents down, according to data to be released today by Reis Inc.

Businesses that needed to lease space took advantage of the market weakness to extract concessions out of landlords. But the trends exacerbated financial woes for owners, especially those who owe more on their mortgages than their properties are worth.

The office vacancy rate nationwide rose to 15.2% from 14.5% in the previous quarter, and likely will surpass 19.3% over the next year, according to Reis, a New York firm that tracks commercial property. That would put the vacancy above the level seen in the real-estate bust of the early 1990s, the worst on record.

Effective rents, which include free rent and other landlord concessions, fell 2% in the first quarter to a national average of $24.16, the largest drop since the first quarter of 2002, according to Reis. Sublet space, on average, is going for between 10% and 15% less than what landlords are charging.

The weakening commercial real estate market is posing yet another threat to the ailing economy because it's causing the value of buildings to plummet, often to less than the amount of their mortgages. In one closely watched transaction earlier this week, the marquee John Hancock Tower in Boston was valued at $660.6 million in a foreclosure auction, less than half of its $1.3 billion price in 2006. Washington policy makers are scrambling to extend bailout programs to help shore up commercial real estate.

Up until now, many have expected commercial real estate to fare better than the housing market, thanks to the lack of rampant overbuilding in the recent cycle. But supply is being dumped on the market instead from layoffs. With as many as 1.5 million jobs expected to be cut this year, more than 50 million square feet of office space is expected to be emptied out for the full year, projects Reis. "We're only at the beginning of a hurricane that may continue for at least the next 18 to 24 months," said Reis research director Victor Calanog.

Tenants are cutting great deals. Last month for instance, Willis Group Holdings Ltd., a London-based insurance broker, pulled off a coup by getting the naming rights to the Sears Tower in Chicago in its new leasing deal with the 110-story building. Willis agreed to lease more than 140,000 square feet of space in the tower as it moves to consolidate five offices in one location. Under the 15-year leasing pact, Willis says it will pay $14.50 per square foot. That compares with average rental rates in the building that are around $17.67 a square foot, according to CoStar Group Inc.

"It's a positive market for tenants, but the smart landlords keep their buildings occupied" before the market gets even worse for them, said Carmine Bilardello, senior vice president of global real estate and facilities at Willis.

Some regional markets are getting hit harder than others. In general, the markets with less exposure to financial services, such as the Washington, D.C. area, appear to be weathering the storm better. Houston showed the biggest jump in rents for the first quarter, though its slight up-tick in vacancy indicates uncertainty as to whether such positive rent growth can be sustained.

But New York City is getting clobbered. Suffering from an unprecedented contraction in the financial-services sector, Manhattan is registering record-high deteriorations in both empty space and rents. Vacancy in New York increased two percentage points in one quarter, from 8% to 10.2%, the single largest quarterly jump in vacancy since Reis began publishing quarterly performance data in 1999. New York rents fell 5.2% to $52.83.

As recently as the end of 2007, the top of the market, more than 20 office buildings in New York commanded asking rents above $100 per square foot. But today, fewer than 10 office buildings can claim that price, according to Reis and brokers.

Meantime, nationwide, more landlords are being forced to sell properties as they struggle to repay debt. Currently, there are about $8.8 billion worth of distressed office assets, or 211 properties, and that number is growing by about 30 properties each month, according to Real Capital Analytics.

Landlords who are "under water" Ã¢â¬â and those who lent to them Ã¢â¬â are facing greater losses. More than a quarter of the $524.5 billion of commercial mortgages on banks' books that will mature in the next four years are backed by real estate that is now worth less than the mortgage, according to Foresight Analytics, a research firm in Oakland, Calif. That underscores the potential for big losses faced by U.S. banks just as they are still reeling from the home-mortgage meltdown.